Debt deal reveals empty toolbox

HONG KONG – When President Barack Obama signed into law the bill increasing the debt ceiling to $16.7 trillion, Americans might have breathed a sigh of relief that the danger of default is over — for now (and probably until spring 2013).

Although rating agency Standard & Poor’s downgraded the top AAA rating for U.S. debt by one notch to AA-plus, Moody’s confirmed its AAA rate with a negative outlook. So, the U.S. will not jump from the frying pan into the fire of a downgrade by all three leading credit rating agencies, but it has leaped into a pan of water that is on the boil.

The shenanigans that pass as politics in the United States have exposed yet again the danger of the world’s reliance on the U.S. and the fragility and deficiencies of the global financial system. When it comes to collateral damage, the most vulnerable country — after the U.S. itself — is probably Japan.

As a sign of the changing times, China has been vociferous in complaining about the dangerous games of U.S. politicians. The official Xinhua news agency in an English editorial claimed that the final agreement “failed to defuse Washington’s debt bomb for good, only delaying the immediate detonation by making the fuse an inch longer.” China’s Dagong Global Credit Rating Company downgraded the U.S. from A+ to A, citing the United States’ “declining ability to repay its debts.”

China of course has a vested interest in the U.S. in the shape of massive $3.3 trillion foreign exchange reserves, mostly invested in American debt instruments.

Stephen Roach, a faculty member at Yale University and nonexecutive chairman of Morgan Stanley Asia, warned that China, as the biggest foreign buyer of U.S. debt, “will soon say ‘enough’. Then the big question is: In the absence of Chinese demand for treasuries, how will the U.S. fund itself without suffering a sharp drop in the dollar and/or a major rise in real long-term interest rates?”

Roach believes that China can achieve its threat to stop buying U.S. treasuries by raising consumption as a share of GDP, thus absorbing surplus savings and bringing the current account into balance or even a slight deficit by 2015. This may prove easier done on paper than in real economic life. Even if successful, it would still leave China and Japan each with a more than trillion dollar hoard of treasuries vulnerable to falls in the value of the U.S. dollar.

Beijing protests too much in blaming only the U.S.: It bought U.S. treasuries as part of a Faustian deal allowing China to use exports as the main engine of its rapid economic growth.

Professor Michael Pettis of Peking University eloquently understands China’s tradeoff. He points out in his blog: “The U.S. has been arguing for years that China had to raise the value of the currency in order to rebalance the global economy and bring down China’s current account surplus and, with it, the U.S. deficit. China responded that it could not do so without causing tremendous damage to its economy and that anyway the problem lay with the U.S. propensity to consume. For that reason China continued to accumulate U.S. dollar assets.

“As it bought U.S. government bonds, it was able to generate higher domestic employment by running large trade surpluses, with corresponding deficits in the U.S. Remember that net capital exports are simply the obverse of trade surpluses (or, more correctly, current account surpluses), and one requires the other. If China buys huge amounts of dollars, the U.S. must run a deficit.”

Pettis correctly adds that, whoever you think is right, it is not America’s obligation to be thinking of maintaining the value of the China’s portfolio: It should be concerned about domestic inflation and the value of the dollar for its own economy.

Washington and the whole U.S. should be worried that Obama and the Congress nearly tore the country apart arguing over something that was a red herring. The debt ceiling had previously been raised 74 times since March 1962, so it was hardly a big deal to lift it again.

With unemployment still at 9.2 percent two years into a supposed economic recovery, former Treasury Secretary and White House adviser Larry Summers is right that the jobs deficit should be the No. 1 priority. Get Americans working again and income and tax revenues will rise to trim the deficits.

The heralded deal does nothing to solve the problems of the U.S. living beyond its means. Even if all the $2.4 trillion spending cuts are made smoothly, they will not be sufficient, yet by emphasizing cuts and only cuts, the already weak recovery could be in jeopardy. Republicans believe they have taken tax rises completely off the table, this at a time when the very richest 400 Americans pay only 18 percent of their income in taxes.

Worst of all, Obama has been gravely wounded politically. Even though he has slithered to the right in the last two years, he was held to ransom by tea party Republicans who set the agenda. The standard joke in Washington is that Obama is leading from the rear. He has one chance now to rescue his diminishing reputation and help the U.S. — by letting the tax cuts of the George W. Bush era expire next year, which would add $3.6 trillion to revenues over 10 years and show that the U.S. again means business.

The world cannot disregard the U.S. It still accounts for 27 percent of global output. The U.S. dollar is still the world’s dominant currency, with 45 percent of global trades, and U.S. treasuries and other American agency debts are still the most liquid reserve assets, almost 65 percent of global reserves.

China promised to diversify from dollars, but faces the dilemma of where to run to: The future of the euro, heralded as the best bet against the dollar, looks shaky; the yen and Swiss franc are small globally; gold is limited in supply and pays no interest.

Once again, the crisis has exposed the threadbare nature of the global financial system. It is time for China to consider its international obligations and make the yuan more international, with all the awkward implications for domestic policymaking. And it is time too for the International Monetary Fund to look again at creating a new reserve currency.

Meanwhile, Japan is threatened with the greatest collateral damage. Just when economists and foreign exchange traders were predicting that the yen would settle in the 85-90 range against the U.S. dollar, along came the fight over the U.S. debt ceiling and the yen soared to 76 as a safe-haven currency.

Japan’s authorities intervened last week to weaken the yen to 78-79, but that was temporary relief. The yen is too high for many of Japan’s big companies to make a profit — grim news when exports account for more than half of Japan’s growth.